Too Big to Fail

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Can banks become “too big to fail”, and should they be allowed to stay that way?
On September 15th 2008, the investment bank Lehman Brothers filed for bankruptcy. It was, and still is, the biggest bankruptcy filing in U.S. history , with Lehman’s holding $691 billion in assets at the time. The event was the catalyst for the current financial crisis. By the end of trading that day, $700bn had been wiped off the global stock markets. The Dow Jones had plummeted 500 points, its biggest drop since the terrorist attacks of 9/11 . Despite rumours and knowledge that Lehman’s was struggling, with its share price dropping daily, the huge drop in the financial markets was due to the huge shock. No-one had been expecting this, as it was anticipated that the U.S. government would intervene and bail out the bank, as it had done previously for another investment bank Bear Stearns, and for the mortgage firms Freddie Mac (Federal Home Loan Mortgage Company) and Fannie Mae (Federal National Mortgage Association) earlier on in that month. Everybody had assumed that Lehman’s was simply too big to fail.

The term “too big to fail” has become a phrase used to describe banks that are so interconnected, so large and so strategically important that if they were to fail the consequences could be catastrophic for the economies they inhabit . In November 2011, the Financial Stability Board released a list of 29 banks worldwide that it considered to be too big to fail, and gave its definition as “systematically important financial institutions are financial institutions whose distress or disorderly failure, because of their size, complexity and systemic interconnectedness, would cause significant disruption to the wider financial system and economic activity” . There is an intense debate as to whether banks should be allowed to be too big to fail or not. Those in favour consider the idea that those institutions that are too big to fail should be given special status by the governments and central banks. They also think the institutions should be the recipients of special protective policies that shield them from legislation that may harm them.

On the other side, there are a lot of critics of the “too big to fail” train of thought. One of the main issues is the moral hazard problem that arises. If the banks know that the government will bail them out once they start to get into financial difficulties, then they will seek to profit from it. They will take higher and higher risks, and act more dangerously as they know they have a safety net to fall back upon. Opponents argue that if an institution is too big to fail then, instead of protective policies being gifted to it, much stricter regulations should instead be applied to prevent bankers from taking too many risks. Some go as far as to suggest that if the bank is too big to fail, then it is simply too big, and should be broken up. Proponents of this idea include Alan Greenspan, former Chairman of the Federal Reserve , and Mervyn King, the Governor of the Bank of England . Others suggest that no bank is too big to fail, and if it gets to the stage where a bailout is required then the bank should just be forced to go into liquidation.

This topic is so interesting because of its massive impact upon the global economy at this current time. The sub-prime mortgage crisis, the collapse of many financial institutions and the massive levels of government bailouts have dominated the political agenda for the past four years or so, and are one of the causes of the recession we currently find ourselves in.

Whilst rather outnumbered by the number of critics of too big to fail ideas, there are nevertheless a large number of people who consider that banks should be allowed to be and to become too big to fail. One area that they point to as a real asset is the sheer size of the bank itself. Being so large, they can conduct large financial operations using enormous sums of money. This allows them to...
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